Question

1.) When is it appropriate to use the income approach?

2.) What are the pros and cons of using the income approach?

3.) Describe what pre-tax and after-tax information is.

4.) What is the capitalization of benefits method?

5.) What is the discounted future benefits method?

6.) What is the excess earnings method?

Answer 1

1.Income Approach Definition
Bill wants to buy a rental property. Since this won't be the house where he lives, his main concern is making a profit. An investor's point of view on value is often different than a retail buyer. Bill might be willing to overpay for his own house, but a rental should be treated as a business decision. An income approach for appraisal is an ideal method in this case.

The income approach to property valuation is suitable for income producing real estate. It weighs the potential income of the property to the purchase price. Within the approach, there are three common techniques. These include direct capitalization, discounted cash flow, and gross income multiplier methods.

Direct Capitalization
Direct capitalization is calculated by dividing the net operating income by the desired capitalization rate (cap rate). The capitalization rate formula is:

capitalization rate = net operating income / sale price

2 P.ros & Cons: The main advantage of this approach is the simplicity of its application, since the calculation of value is relatively straightforward and does not require any significant forecasts of future business activity or estimation of discount or capitalization rates. However, the approach can require costly appraisals of business assets and ignores the current and future earning power of the company. As such, this approach is best used for capital-intensive businesses, businesses with no current or projected operating income or non-operating entities such as real estate and investment holding companies.

3.
A pretax contribution is any contribution made to a designated pension plan, retirement account, or another tax-deferred investment vehicle for which the contribution is made before federal and municipal taxes are deducted. For example, if you put in $10,000 to a 401(k), you do not have to pay tax on that $10,000 of income in the year that it was earned. Pretax contributions are the government's way of encouraging you to save for your retirement.

After-tax income is the net income after the deduction of all federal, state, and withholding taxes. After-tax income, also called income after taxes, represents the amount of disposable income that a consumer or firm has available to spend.

When analyzing or forecasting personal or corporate cash flows, it is essential to use an estimated after-tax net cash projection. This estimate is a more appropriate measure than pretax income or gross income because after-tax cash flows are what the entity has available for consumption.

4.Capitalization of earnings is a method of determining the value of an organization by calculating the worth of its anticipated profits based on current earnings and expected future performance. This method is accomplished by finding the net present value (NPV) of expected future profits or cash flows, and dividing them by the capitalization rate (cap rate). This is an income-valuation approach that determines the value of a business by looking at the current cash flow, the annual rate of return, and the expected value of the business

5.Discounted future earnings is a method of valuation used to estimate a firm's worth. The discounted future earnings method uses forecasts for the earnings of a firm and the firm's estimated terminal value at a future date, and discounts these back to the present using an appropriate discount rate. The sum of the discounted future earnings and discounted terminal value equals the estimated value of the firm.

6.Another earnings-based method is excess earnings. This method discounts company earnings based on two capitalization rates: a rate of return on tangible assets and a rate attributable to company goodwill. The method is often described as a hybrid method because it takes into account the company’s asset values as well as discounts expected cash flows. The following equation represents the valuation based upon the two rates of return:

V = Ea / R a + Eg / Cg